3/2010 Asset Prices and Financial Frictions in Monetary Transmission: The Case of Latvia
( 1.52 MB)
Kristine Vitola, Ludmila Fadejeva

The purpose of this paper is to quantify the role of financial frictions in Latvia's monetary transmission. Our model extends M. Iacoviello (9) framework along three dimensions. First, we introduce open-economy features by allowing imports of foreign consumer goods and borrowing from abroad. Second, we relax the assumption of fixed housing stock, allowing for investment. Finally, we assume a risk premium on foreign borrowing, which depends on net foreign asset position. We estimate the model by Bayesian approach and compare impulse responses to shocks under various scenarios. In addition to the baseline scenario, we explore the importance of tighter borrowing constraints and higher foreign risk premium elasticity in the model dynamics. Our findings show that tighter credit constraints weaken the transmission of shocks to housing demand and consumption. In the case of foreign interest rate and risk premium shocks, higher risk premium elasticity lessens the effect of monetary transmission on the domestic economy through higher cost of external funds.

Keywords: financial frictions, monetary transmission, asset prices, DSGE model, Bayesian approach

JEL classification: C11, E32, E44, E52, R21
2/2010 Quality and Variety of Exports from the New EU Member States: Evidence from Very Disaggregated Data ( 432 KB)
Konstantīns Beņkovskis, Ramune Rimgailaite

According to trade theories, the average quantity of exported goods is not the only parameter of export performance – the variety and quality of exports also play an important role. The goal of this paper is to evaluate the variety and quality of exports from the new EU Member States Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia and Slovenia (NMS) in 1999–2009. The analysis is done on the basis of methodology proposed by R. C. Feenstra (7) and further developed by D. Hummels and P. Klenow (13), and Ch. Broda and D. E. Weinstein (4). Although unit values play an important role in defining export quality, the calculations herein take into account also market shares and the level of monopoly power of firms in a particular market. In addition, this study contributes to the existing literature by providing a different way of evaluating the variety assuming that the number of exported brands follows the Poisson distribution. The calculations show that exports from NMSs in 2009 were of lower quality in comparison with German exports: relative quality was ranging between 0.30 and 0.55. It was found that all NMSs significantly increased their average number of brands exported to the EU market; moreover, all NMSs were able to increase the average quality of their exports during the 10-year reference period. Finally, relative quality is much more stable than relative prices, providing evidence that the measure of relative quality developed herein is better than the traditional proxy, i.e. relative export prices, as it does not include relative costs of production but reflects structural factors.

Keywords: new EU Member States, exports, quality, variety

JEL classification: C43, F12, F14, O52
1/2010 LATCOIN: Determining Medium to Long-Run Tendencies of Economic Growth in Latvia in Real Time ( 355 KB)
Konstantins Benkovskis

This paper presents a method of estimating the current state of Latvia's economy. The evaluation object is medium to long-run growth of real GDP, but not actual GDP itself, which helps to filter out various one-off effects and focus on medium and long-run tendencies. Our indicator, called LATCOIN (Latvia's Business Cycle Coincidence Indicator), could be viewed as a simple adaptation of EUROCOIN for Latvia with some changes in methodology. LATCOIN is a monthly estimate of the medium to long-run growth of Latvia's real GDP, which is produced on the 9th working day of the next month. Using a large panel of macroeconomic variables, few smooth unobservable factors describing the economy are constructed. Further, these factors are used for the estimation of LATCOIN.

Keywords: Latvia's real GDP, band-pass filter, coincidence indicator, generalised principal components, real-time performance, turning points

JEL classification codes: C22, C50, E32


4/2009 Advantages of Fixed Exchange Rate Regime from a General Equilibrium Perspective ( 611 KB)
Viktors Ajevskis, Kristine Vitola

In this paper we estimate a small open economy DSGE model for Latvia following Lubik and Schorfheide (2007) using Bayesian methods. The estimates of the structural parameters fall within plausible ranges. Simulation results suggest that under inflation targeting inflation turns out to be more volatile than under the peg in the case of Latvia. Additional concern for output stabilisation accounts for lower inflation variability while it is still higher than under existing exchange rate regime with ±1% fluctuation bands. The model results therefore support the existing exchange rate policy.

Key words: DSGE, small open economy, exchange rate policy, Bayesian estimation

JEL classification codes: C11, C3, C51, D58, E58, F41
3/2009 Measuring Total Factor Productivity and Variable Factor Utilisation: Sector Approach, The Case of Latvia ( 1,22 MB)
Ludmila Fadejeva, Aleksejs Melihovs

This research constructs estimates of total factor productivity (TFP) growth for six sectors of the Latvian economy for the period 2000-2008, using a sectoral quarterly data set. Estimates are obtained by controlling for qualitative changes in production factors and assuming a mechanism for capturing changes in the utilisation of labour and capital. The paper delivers two main results. First, the use of indicators for labour and capital utilisation intensity allows for minimisation of fluctuations in the TFP measure and makes it less output growth dependent compared with the Solow residual approach. Second, the comparison of both methods shows that the estimate of the TFP growth obtained by the Solow residual approach might be undervalued for manufacturing, electricity, gas and water supply, wholesale and retail trade as well as hotels and restaurants, while overvalued for the growth in the transport, storage and communication sector of the Latvian economy.

Key words: Total Factor Productivity, Solow residual, factor utilisation

JEL classification codes: C22, D24
2/2009 The Assessment of Natural Rate of Unemployment and Capacity Utilisation in Latvia ( 511 KB)
Aleksejs Melihovs, Anna Zasova

Inflation and its dynamics are among the most important indicators in the focus of such economic agents as producers, consumers, investors, and monetary and fiscal policy makers. Risks of high inflation or deflation enhance the need to profoundly investigate factors and causes that could underpin materialisation of such risks in the economy and to seek for steps to avert adverse effects of unwelcome inflationary dynamics. Optimal capacity utilisation is one of the ways to escape endogenous pressures that increase inflation or cause deflation.
The study pursues the aim to assess short-term relationships between the capacity utilisation rate and inflation. The authors have set a target to determine the capacity utilisation rate at which no pressure is exerted upon inflation and to show whether the capacity utilisation rate of the Latvian economy was an underlying factor that caused a rise in inflation after the EU accession.

Key words: NAIRU, NAIRCU, Kalman filter

JEL classification codes: C51, E31, D24

Research published: Assessment of the natural rate of unemployment and capacity utilisation in Latvia. Baltic Journal of Economics, 2009, No. 9 (2), pp. 25-46. Available:
1/2009 A Convergence Model of the Term Structure of Interest Rates ( 415 KB)
Viktors Ajevskis, Kristine Vitola

This paper develops a convergence model of the term structure of interest rates in the context of entering the EMU. Compared with the other models developed so far in this field, our model specification ensures convergence of the domestic short-term interest rates to the euro area ones. We achieve this convergence by stating that the spread between the domestic and euro short-term interest rates follows the Brownian bridge process. We also develop an econometric counterpart of the theoretical model. To address the problem of nonstationarity and nonlinearity of the model, the extended Kalman filter for coefficient estimation is applied.

Key words: term structure of interest rates, the Brownian bridge, the EMU, nonlinear Kalman filter.

JEL classification codes: E43, F36, G12, G15

Research published: A Convergence Model of the Term Structure of Interest Rates. Review of Finance, 2008, pp. 1-21. Available:


5/2008 Short-Term Forecasts of Latvia's Real Gross Domestic Product Growth Using Monthly Indicators ( 697 KB)
Konstantins Benkovskis

The conjunctural information from monthly indicators, e.g. industrial production, retail trade turnover, M3, confidence indicators, etc. could partly replace GDP data before the first official release is published. It is possible to incorporate monthly indicators into short-term forecasting models of GDP using quarterly bridge equations or state space models. In many cases monthly indicators are released with a lag, and GDP forecasts based on actual figures are available only shortly before the official release. To eliminate this drawback, missing observations of monthly indicators could be forecasted using simple univariate time-series models.
To perform real-time analysis of the forecasting performance of bridge equations and state space models, a real-time database containing real GDP series with 28 vintages of quarterly real GDP was created.
According to calculations, only bridge equations and state space models containing M3 monthly data perform better than the benchmark ARIMA model. Both model types using M3 provide valuable information forecast for the first and final releases of GDP. This does not mean, however, that other conjunctural indicators should not be used in forecasting, as the analysis does not take into account possible future changes in links between monthly indicators and quarterly GDP growth.

Key words: bridge equations, state space model, out-of-sample forecasting, real-time database, interpolation.

JEL classification: C22, C53, E37
4/2008 Structural Transformation of Exports in a Product Space Model ( 319 KB)
Kristine Vitola, Gundars Davidsons

The research paper deals with an export structural transformation model providing for a transition from the production and exports of goods with low value added to the production and exports of goods with high value added. It is essential for the improvement of a nation's welfare, as observations show that in a longer perspective the level of economic development is related to the degree of export sophistication. The speed of structural transformation depends on the distance in the product space between the potential export goods and the existing export goods with revealed comparative advantage. Estimations within the research suggest that the relative distance of Latvian export goods to goods with comparative advantage is rather small. Potential of almost all groups of currently produced goods to act as drivers of development has already been exhausted to a large extent. In order to enhance sophistication of Latvia's export structure, the production of goods with their implicit income level exceeding the current average weighted value of the export basket should be augmented. Potential goods for exports include pharmaceutical products, medical, precision and optical instruments as well as chemicals and chemical products. However, it is rather unlikely that comparative advantage in these products can be developed without extra supportive measures taken by the Government.

Keywords: structural transformation, comparative advantage, export sophistication

JEL classification: F14, F19, O33, O40

3/2008 The Baltic States and Europe: Common Factors of Economic Activity ( 751 KB)
Ludmila Fadejeva, Aleksejs Melihovs

This paper aims at characterising fluctuations of economic activity that are common for the Baltic States, CEE countries, euro area countries and Russia. The real standardised GDP quarterly growth is chosen as an indicator of economic development of the countries. Three methods are employed: static factor analysis, dynamic factor model and dynamic correlation. Special attention is given to the analysis of Latvian economy.
The results of the study show that the Baltic economies are similar in economic development and share a common factor. After 2000, the real standardised GDP growth in the Baltic States became more correlated with the GDP growth of the main euro area countries indicating growing synchronisation of economic development between these country groups.
The role of the main final demand components (exports, consumption and investment) in explaining common fluctuations in the real standardised GDP growth in the Baltic States is evaluated by analysing common factors for each component and dynamic correlation between components for each country.

Keywords: business cycle synchronisation, dynamic factor model, dynamic correlation

JEL classification: E32, F20, C10

Research published: The Baltic States and Europe: Common Factors of Economic Activity. Baltic Journal of Economics, 2008, No. 8 (1), pp. 75-96. Available:
2/2008 Dynamic Factor Models in Forecasting Latvia's Gross Domestic Product ( 655 KB)
Viktors Ajevskis, Gundars Davidsons

The study aims at evaluating how useful the application of models using large panels of data in forecasting Latvia's GDP is. Two factor models have been used: the Stock-Watson factor model and the generalised dynamic factor model. The forecast findings by the two models have been compared with the results obtained by the benchmark autoregressive model. The results suggest that compared with simpler autoregressive models both the Stock-Watson factor model and the generalised dynamic factor model ensure forecast improvement, which, however, has not been statistically significant if statistical tests are used.

Keywords: forecasting, factor models, large cross section

JEL classification: C32, C33, C53
1/2008 Is there a Bank Lending Channel of Monetary Policy in Latvia? Evidence from Bank Level Data ( 480 KB)
Konstantins Benkovskis

The goal of this paper is to explore the role of the banking sector in transmission of the Bank of Latvia's monetary policy and to check the existence of the bank lending channel in Latvia. For empirical investigation of the bank lending channel in Latvia, we use the approach that builds on the standard panel regression. The evidence on the bank lending channel is obtained by estimating a bank loan function that takes into account not only the monetary policy indicator and macroeconomic variables, but also bank-specific differences in the lending reaction to monetary policy actions.
Empirical analysis shows that some banks in Latvia have statistically significant negative reaction to a domestic monetary shock; however, the weighted average reaction of the total lats loan growth is not statistically significant. A domestic monetary shock has only a distribution effect and affects banks that are small, domestically owned and have lower liquidity or capitalisation. The bank lending channel is limited only for the supply of lats loans, which dramatically reduces the importance of this channel.

Keywords: monetary policy transmission, bank lending channel

JEL classification: C23, E52, G21


4/2007 Inflation and Inflation Uncertainty in Latvia ( 450 KB)
Viktors Ajevskis

The paper considers interrelation between inflation and inflation uncertainty in Latvia. The monthly growth in CPI in the period from January 1994 to June 2007 has been used as an inflation measure. The application of the GARCH-M model with lagged inflation in GARCH equation proves that a positive relationship between inflation and inflation uncertainty does exist. It suggests that increased inflation uncertainty raises inflation, and, vice versa, increased inflation is a cause for higher uncertainty about inflation in the future.

Key words: inflation, inflation uncertainty, GARCH-M

JEL classification codes: C22, E31, E37
3/2007 Estimation of the Phillips Curve for Latvia ( 882 KB)
Aleksejs Melihovs, Anna Zasova

The current paper aims at estimating the formation mechanism of business inflation expectations to find out how the latter affect the inflation dynamics. To attain this goal, the authors estimated the traditional Phillips curve, new Keynesian Phillips curve and hybrid Phillips curve. The results obtained testify to a better explanatory power to describe the dynamics of Latvia's core inflation of the hybrid Phillips curve compared with the traditional and new Keynesian Phillips curves. Moreover, the outcomes of the research indicate that companies in Latvia adjust their output prices quite frequently implying that the pass-through of changes in inflation expectations to actual prices is quite prompt.

Key words: Phillips curve, new Keynesian Phillips curve, hybrid Phillips curve, inflation persistence

JEL classification codes: C22, E31
1/2007 Inflation Expectations in Latvia: Consumer Survey Based Results ( 1,21 MB)
Konstantins Benkovskis, Daina Paula

The objective of this study is the quantification of inflation expectations in Latvia using the results of consumer surveys and the assessment of the impact inflation expectations have on actual inflation. In order to attain the objectives set, the authors of the study quantified inflation expectations applying the widely accepted probability approach and produced a small-scale VAR model capturing actual inflation and the quantified inflation expectations. Both the surveyed balance sheet data and quantified values of inflation expectations confirm that inflation expectations strengthened substantially prior to Latvia's accession to the EU. The findings of the VAR model with inflation expectations indicate that inflation expectations have a statistically significant impact on inflation in Latvia. The response of inflation expectations to inflation and domestic demand shocks is positive, although a deviation implies that the response to a domestic demand shock is not statistically significant.

Key words: inflation expectations, survey data, VAR model

JEL classification codes: C32, C83, D84, E31

Extended research published: The Role of Inflation Expectations in the New EU Member States: Consumer Survey Based Results. Czech Journal of Economics and Finance, 2008, No. 58 (7-8), pp. 298-317. Available:


3/2006 The Role of Production Progress and Human Capital in the Economic Growth of Latvia ( 367 KB)
Aleksejs Melihovs, Gundars Davidsons

The paper sets a goal to assess the significance of production progress and human capital for the Latvian economy and to estimate long-term growth rates of the country's economic development. The authors made an attempt to construct a production function using non-linear modelling. In order to improve the production function model for Latvia, the authors augmented the model by human capital approximation.

Key words: production function, non-linear modelling, human capital, total factor productivity

JEL classification codes: C32, E23, J24, O47
2/2006 Latvia's Macroeconomic Model ( 930 KB)
Konstantins Benkovskis, Dainis Stikuts

The paper presents the first version of Latvia's Macroeconomic Model (LMM) built using the features and structure of an Area-Wide Model (AWM) for the euro area and Multi-Country Model (MCM) for a typical country block of the European System of Central Banks. This is one of the first attempts to create an econometric model that captures the Latvian economy as a whole and simultaneously modells the supply and demand sides, price and fiscal blocks, and the external sector.

Key words: macroeconomic model, Latvia

JEL classification codes: C3, C5, E12, E17
1/2006 A Factor Model of the Term Structure of Interest Rates and Risk Premium Estimation for Latvia's Money Market ( 670 KB)
Viktors Ajevskis, Kristine Vitola

The paper presents the analysis of risk premium of the interest rate term structure for the Latvian money market. On the back of the approach used by F. Diebold, G. Rudebusch and B. Aruoba, it has been assumed that the coefficients of the Nelson–Siegel model are unobservable therefore the model of this research paper has been estimated using the Kalman filter. The risk premium behaviour has been obtained for interest rates of different maturities and forecasting horizons between May 2000 and July 2005. The results obtained indicate that the amount of the risk premium was significant and its volatility substantial between 2000 and 2002. In post-2002 period, its behaviour gradually stabilised and was marked by a downward trend after 2004.

Key words: term structure of interest rates, risk premium, the Nelson–Siegel model, the Kalman filter

JEL classification codes: C32, D84, E43, E47, G10